In their new book “13 Bankers,” Simon Johnson and James Kwak argue that the only way to truly prevent another financial crisis is for Congress and the White House to reduce the size of the nation’s largest financial institutions such as JP Morgan and Bank of America.

Knopf

Johnson, a former chief economist at the International Monetary Fund, and Kwak, a former McKinsey & Co. consultant, argue that anything short of modern day trust-busting on Wall Street will not address the central problem facing the financial system: banks that are “too big to fail.”

The bailout only made the big banks, bigger, more influential and systemically risky, and none of the financial reform proposals currently before Congress will address those issues, the authors say.

The authors also argue that such a break up is necessary to free the grip that Wall Street holds over Washington lawmakers and regulators, both Democrats and Republicans. The book title refers to comments made by White House adviser Larry Summers about the 13 bankers that were in his office in late 2008 warning that if the bailout didn’t pass there would be financial catastrophe.

“As high finance becomes less glamorous and a little more like just another business, its ideological sway over the Washington establishment will begin to fade…the financial crisis has made at least some people think that everything is not right with the Wall Street view of the world; weakening the big banks will help fuel that healthy skepticism.”

Here is an excerpt of “13 Bankers,’’ courtesy of publisher Knopf. The book is due to be released March 30th

*****

……Whatever the final form of the legislation, the problem of too big to fail will probably remain with us. But this does not mean that it cannot be solved. It only means that it may take several years, and several sessions of Congress, to solve.

The solution must be economically simple, so it can be effectively enforced; the more complex the scheme, the more susceptible it is to regulatory arbitrage, such as reshuffling where assets are parked
within a financial institution’s holding company structure. And the solution must change the balance of political power, so it will last.

The simplest solution is a hard cap on size: no financial institution would be allowed to control or have an ownership interest in assets worth more than a fixed percentage of U.S. GDP. Determining the
exact percentage is a technical problem that we do not claim to have solved, but the problem can be simply stated: the percentage should be low enough that banks below that threshold can be allowed to fail without entailing serious risk to the financial system. As a first proposal, this limit should be no more than 4 percent of GDP, or roughly $570 billion in assets today. U.S. banks could choose to operate globally or only in the United States, but in either case the size limit would be set relative to
the U.S. economy, and offshore activities would count toward the limit. (U.S. subsidiaries of foreign banks would also have to comply with the size cap and with all U.S. financial regulations.) Existing megabanks would have to break themselves up in a way that maximizes value to their shareholders; the resulting smaller institutions would be free to compete fiercely for customers and profits.

Hard limits on the size of financial institutions have a precedent. Since 1994, the United States has had a rule prohibiting any single bank from holding more than 10 percent of total retail deposits— an
arbitrary cap designed to prevent any one entity from becoming too central to the financial system. This rule had to be waived in 2009 for JPMorgan Chase, Bank of America, and Wells Fargo, demonstrating how recent growth and consolidation have rendered our previous safety measures obsolete.

The most commonly discussed alternative basis for a size cap is a fraction of total financial assets in the economy. However, this number can rise dramatically in a bubble. In addition, as financial development progresses, financial assets tend to rise relative to GDP and relative to the government’s budget, which ultimately bears the brunt of any bailout.

An overall asset cap is a necessary condition for financial stability, but it is not a sufficient condition. The acute phase of the recent crisis was triggered not by mammoth commercial or savings banks,
although some of them collapsed or nearly collapsed during the crisis, but by (modestly) smaller, risk-seeking investment banks; Bear Stearns had only $400 billion of assets at the end of 2007.78 Because a financial institution could load up on $570 billion of the riskiest assets it can find, there must also be lower limits for banks that take greater risks, and these limits must take into account derivatives, off- balance- sheet positions, and other factors that increase the damage a failing institution could cause to other financial institutions. That way financial institutions that engage in riskier activities will have to be smaller than institutions that hold safer assets, in order to limit the collateral damage their failure could cause. This will require a technical formula that goes beyond the scope of this book,* but again the goal is simple: all banks, including risk-seeking ones, should be limited to a size where they do not threaten the stability of the financial system. As an initial guideline, an investment bank (such as Goldman Sachs) should be effectively limited in size to 2 percent of GDP, or roughly $285 billion today. (If it were to choose a riskier mix of activities in the future, its effective maximum size would fall accordingly.)

Determining where to set these limits is a problem shared by all parties to this debate. Every proposed solution assumes that regulators have some way of identifying TBTF institutions so that they can take
special precautions against them— which means that there must be a way of calculating the systemic importance of different institutions. If the problem is simply and clearly stated— establish limits such that no bank is too big or too important to fail— it can be solved by people with access to the right data about the financial system. These limits should not be set by regulatory agencies, which could then nudge them upward as memories of the crisis fade and faith in free markets returns. The limits should be set by Congress, with sufficient expert input, and then enforced by regulators.

To be clear, size limits should not replace existing financial regulations. A world with only small banks, but small banks with minimal capital requirements and no effective oversight, would not be dangerous
in the same way as today’s world of megabanks, but it would be dangerous nonetheless; it was the collapse of thousands of small banks that helped bring on the Great Depression. More generally, it would be naive to assume that we can predict today all the ways that financial institutions will find to take on more risk and get into more trouble. Therefore, enhanced capital requirements and closer prudential regulation, as proposed by the Obama administration, are also necessary.

Size limits, however, provide protection against both the systemic risk and the competitive distortions created by financial institutions that are too big to fail, which are not adequately addressed by existing regulations.

We believe these limits should work out to no more than 4 percent of GDP for all banks and 2 percent of GDP for investment banks, but that is a debate we are willing to have. Why 4 percent and 2 percent? The fundamental tradeoff is between safety and efficiency. A lower size limit makes the financial system safer, because it will be less vulnerable to the failure of a single bank or a handful of banks; however, draconian size limitations could introduce unintended consequences if, for example, investment banks are no longer able to maintain sufficient trading volume in global markets.

Personally we would prefer even lower limits, for two main reasons. First, Bear Stearns had only $400 billion in assets— implying that, for a risk-loving investment bank, $285 billion may still be large enough
to threaten the financial system. Second, lower limits would increase competition and reduce the potential political power of any single company.

However, we think that 4 percent and 2 percent present a reasonable compromise with people who believe that the real economy needs large banks. Members of the Obama administration, as described
above, have said that it is impossible to “turn back the clock.” A 4 percent cap would only roll back the clock to the mid-1990s. At that time, the largest commercial banks— Bank of America, Chase Manhattan, Citibank, NationsBank— each had assets roughly equivalent to 3–4 percent of U.S. GDP. On the investment banking side, Goldman Sachs and Morgan Stanley only passed the 2 percent threshold in 1997 and 1996, respectively; at the time, they were the two premier investment
banks in the world, and no one thought they were unable to meet their clients’ needs.

On the one hand, it can be argued that the world has changed since the mid-1990s. But by how much? Thomas Philippon has estimated how much of the growth of the financial sector (measured by its share of GDP) can be explained by increasing demand for corporate financial services from the nonfinancial sector. His analysis shows that demand for finance around 2007, after a spike around 2000, was only 4 percent higher (as a share of GDP) than in the 1986–1995 period (while the corporate finance share of GDP had grown by 31 percent).

On the other hand, there is no reason why increased demand for finance can only be met by larger firms, rather than more firms. There is also no proof that the mid-1990s economy required commercial
banks as large as 4 percent of GDP— which were already the product of what seemed then like blockbuster mergers— or investment banks as large as 2 percent of GDP.

Saying that we cannot break up our largest banks is saying that our economic futures depend on these six companies (some of which are in various states of ill health). That thought should frighten us into action.

Some commentators worry that smaller banks would hurt the competitiveness of our financial system; a cap on the size of U.S. banks would lead our banks to relocate overseas and do nothing to
prevent the growth of megabanks based in other countries.

In an interview, law professor Hal Scott said, “If we break up our banks and Europe doesn’t break up theirs and the Chinese don’t break up theirs, this is going to have an immense impact on who are the players in the international banking system.”82 But this does not mean that American companies would be starved of capital. In a free market, financial intermediation is driven by real economic activity; smaller U.S. banks (and a bank with $500 billion in assets is by no means a small bank), or
the U.S. subsidiaries of foreign banks, would step in to fill the gap. U.S. banks already face foreign competition in many financial markets; U.S. companies are perfectly happy buying their interest rate
swaps from Deutsche Bank rather than JPMorgan, and the products work just as well.

The more serious issue is not that competition from foreign megabanks will hurt American nonfinancial companies (those foreign banks will be competing for the business of U.S. companies), but that foreign
megabanks will continue to pose a risk to the global financial system.

The ideal solution would be for all major countries to implement similar limits on bank size. One avenue for international coordination could be the World Trade Organization; any government that tolerates
domestic banks that are too big to fail is subsidizing them (by allowing them to borrow money more cheaply than foreign competitors that do not have implicit government guarantees), which is a form
of protectionism.

However, it is never safe to bet on international agreement, and there is no need for the United States to wait for an international solution. First, U.S. subsidiaries of foreign banks will continue to be subject to U.S. prudential regulation— which should take into account whether that subsidiary would be able to withstand a global financial crisis. If a large European bank were to fail, our financial system would be safer if it did not include banks that were too big to fail; the whole point of size limits is to increase the ability of the system to withstand a shock, no matter where it originates. And if European countries want to keep banks that are too big to fail, then their taxpayers will have to
bail them out in case of a crisis.

In effect, foreign governments would be taking on the role of insuring the global financial system against disaster— a role that the Federal Reserve and the Treasury Department played in 2008–2009. Relying on foreign government bailouts alone would not make us invulnerable to crises originating overseas. For example, Switzerland may not be able to afford to bail out UBS should it suffer a major crisis. For this reason, our financial regulators need to evaluate the potential risks created by foreign megabanks and, if necessary, take action to limit our exposure to those banks. But in any case, we would be less exposed than we are today. And the way to start is to create a financial system that is not vulnerable to the collapse of a few towering dominoes. A real cap on bank size will not only level the economic playing field and reduce the incentive for banks to take excess risks predicated on the government safety net, but it will also weaken the political power of the big banks and begin to undo the takeover of Washington by Wall Street that we have chronicled in this book. Without a privileged inner core of thirteen (or fewer) bankers, the financial sector will be composed of thousands of small companies and dozens or hundreds of medium-to-large companies, including hedge funds and private equity firms.

The financial lobby will continue to be strong by virtue of its sheer size, and the community bankers will retain their clout in Congress. But the distortion of the playing field in favor of a small number
of megabanks will come to an end.

This fragmentation of the banking industry should also help dethrone Wall Street from its privileged place in the U.S. economy. The end of “too big to fail” will reduce large banks’ funding advantage,
forcing them to compete on the basis of products, price, and service rather than implicit government subsidies. Increased competition will reduce the margins on fee-driven businesses such as securitization, trading, and derivatives, putting pressure on large banks’ profits. A larger group of competitors will also make it harder for major banks to divert such a large proportion of their profits to
employee compensation; bonuses for traders and investment bankers should fall from the historically obscene to the merely outrageous.

With more competition, it will be harder for a handful of firms to dominate the cultural landscape like Salomon Brothers and Drexel Burnham Lambert in the 1980s or Goldman Sachs today, and perhaps
smart college graduates will find Wall Street a little less compelling. Finance will never go back to being boring— globalization and computers have seen to that— but it should become a little less exciting. This will create a virtuous cycle. As the major banks become a little poorer, their domination of the campaign finance system will wane, as will the allure of the revolving door. As high finance becomes less glamorous and a little more like just another business, its ideological sway over the Washington establishment will begin to fade. Fewer top administration officials will come from a handful of megabanks, and more will come from other parts of the financial industry, or from
nonfinancial industries.

The financial crisis has made at least some people think that everything is not right with the Wall Street view of the world; weakening the big banks will help fuel that healthy skepticism. Finance will never be just another industry. It is too big and too central to the economy, and there is something seductive about a business that deals in nothing but money. But reducing the size, profits, and power of the big banks will begin to restore balance both to our economy and to our political system.

Comments (5 of 6)

Indeed it is extremely interesting for me to read that article. Thanks for it. I like such themes and everything that is connected to them. I definitely want to read more soon.

3:15 pm April 30, 2010

Doug Plumb wrote :

I think that money itself is necessary for all humans in modern society and that it serves the common interest, it should be managed as such. When its management is left to private interest, power is in the hands of a few. Power preserves power and the best way to do that is to increase power. Any argument to restructure a private interest to manage a common interest will be inherently corrupt.

Management of money and the economy has to be accountable to the public interest because it is a public interest rather than the public interest accountable to private interest as it is now.

We need to have a public central bank and exchequer rather than a Crown central bank and exchequer.

3:23 pm April 13, 2010

MARTIN FRIEDLANDER wrote :

We need a Trust Buster like Teddy Roosevelt to bust up these huge financial trusts. I hold nothing but disgust for Ken Lewis, Jamie Dimon, the boys at Goldman Sachs, AIG. The story that just broke about Lehman just topped my list.Can you imagine Dimon stating that all notes should be paid without reductions in principle. There are 2 types of contracts: the legal contract and the social contract. In my opinion the "social contract" trumps the legal contract. In 1787 our founder gave Congress to pass laws regarding bankruptcy. So long as mean spirited Senators like Grassley remain in power, we will have write downs of principal for Corporatioins but none for individuals. As Senator Durbin remarked when the new bankruptcy bill was defeated by the Scrooges of the Senate, Durbin remarked that the Banks own us. We should own the banks since tax payer money bailed out these schlockmeisters of "crap" called CDOs and CDSs where firm like Goldman shorted the schlock bond market by trading Credit Default Swaps. A must read is the "Big Short".

My plan for rescue was to pass a new BK bill to permit homeowners to enjoy the same "cram down" rights as corporations. GM, Chrysler and other majors shed their debt by forcing the debt holders and the unions to take a "forced" haircut.

MC... unbelievable, totally outstanding, excellent article... this book is correct. Just as I predicted and posted in the fall of 2007! "Follow the Yellow Brick Road"! This is the only way to stop massive global greed by these banks including the USG Treasury and of course The USG Fed! Alas... (*IT) has went too far and too fast to stop (*IT)... "NOW"! They are in bed with the USG that's in charge and raping the American Us US Tax Payers... as the Pied Pipper continues to play his flute!

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